Corporate Governance & Your Fiduciary Duty

Corporate Governance & Your Fiduciary Duty Bill Sokol Weinberg Roger & Rosenfeld wsokol@gmail.com

Do You Have A Fiduciary Duty to Engage in Issues of Corporate Governance?

YES

The Simple Logic • If A: Congress enacts ERISA • If B: States each enact own ERISA standard • If C: Congress then enacts Dodd Frank • Then D: Each State Pension Fund MUST engage in Corporate Governance

A: ERISA • ERISA: • “a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries “ (29 USC 1104) • California Constitution • “The members of the retirement board of a public pension or retirement system shall discharge their duties with respect to the system solely in the interest of, and for the exclusive purposes of providing benefits to, participants and their beneficiaries ,minimizing employer contributions thereto, and defraying reasonable expenses of administering the system. A retirement board's duty to its participants and their beneficiaries shall take precedence over any other duty.” (Const. XVI, 17(b)

B. Dodd Frank • Corporate Governance Tools Are Necessary to Protect Shareholders’ Interests • E.g., Title 9 Subtitle G, Sections 971-972 • “Subtitle G—Strengthening Corporate Governance • Sec. 971. Proxy access. • Sec. 972. Disclosures regarding chairman and CEO structures.”

Dodd Frank • Access to proxies to nominate Directors • Nominate up to 25% of Board • SEC Rule 14a-8: expand proxy voting activities • (500+ rules, more to come) • Access to Proxy Voting on Political Expenditures • Non-binding Say on Pay • Non-binding Say on Golden Parachutes • No automatic proxy voting by brokers • Whistle blowing Sanctions • Right to sue Rating Agencies

IT’S INELUCTABLE !

IT’S INEXORABLE !

IT’S INESCAPABLE • If the law states you must act solely on behalf of participants and fiduciaries • And if the law states you must have these tools of corporate governance at your command to protect those participants & beneficiaries • Then You Must Understand and Use These Tools Whenever Necessary to Protect Participants & Beneficiaries • Inverse: What if you do not? Isn’t that a breach of your duty?

IS THAT ALL THERE IS?

“Fiduciary Duty” in Flux • Hundreds of lawsuits in wake of 2008 • Who Decides? • Judges --- Who Are They? • ‘59: 2d ROT: “Prudent Man Rule” • ‘74: ERISA: “Lemming Rule?” • ‘92: 3d ROT: Full Knowledge/Due Diligence • ‘11: SEC & DOL formulating new rules

1959: 2d Restatement of Trusts (ROT) • “Prudent Man Rule” • Trustees have certain legal duties in relation to the management of the trust. The most important duty is the duty of loyalty. Since trustees are the legal owners of the trust property, the duty of loyalty prevents the trustee from taking advantage of the legal ownership to use the trust property for his own benefit. The trustee must act in good faith when entering into transactions and invest prudently.

1974: ERISA“Lemming Rule”? • “a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and …with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims….” • Key Unaddressed Issue: Does a PRUDENT MAN using CARE,SKILL,PRUDENCE & DILIGENCE just follow the crowd????

1992: 3d ROTFull Knowledge/Due Diligence • SECTION 2. STANDARD OF CARE; PORTFOLIO STRATEGY; RISK AND RETURN OBJECTIVES.(a) A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution (b) A trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.(c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:(1) general economic conditions; (2) the possible effect of inflation or deflation;(3) the expected tax consequences of investment decisions or strategies;(4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;(5) the expected total return from income and the appreciation of capital;(6) other resources of the beneficiaries;(7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and(8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.(d) A trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets.(e) A trustee may invest in any kind of property or type of investment consistent with the standards of this [Act].(f) A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee’s representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise.

Investment World in Flux • Financial Crisis Inquiry Commission (FCIC) Report • The Big Short, Freefall, All the Devils Are Here, Too Big to Fail, Aftershock, Griftopia • MPT fundamentally flawed • Exchanges merging & oligopolizing • 7000 publically traded down to 4000 • 60%+ trades done by computers via algorithms

FCIC (1) • “...a fundamental disruption -- a financial upheaval, if you will -- that wreaked havoc in communities and neighborhoods across this country.” • “The impact of this crisis is likely to be felt for a generation.”

FCIC (2) • “We conclude this financial crisis was avoidable.” • “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble.”

FCIC (3) • “We do place special responsibility with the public leaders charged with protecting our financial system, those entrusted to run our regulatory agencies, and the chief executives of companies whose failures drove us to crisis. These individuals sought and accepted positions of significant responsibility and obligation. Tone at the top does matter and, in this instance, we were let down. No one said “no”.

FCIC (4) • “Our financial system is, in many respects, still unchanged from what existed on the eve of the crisis. Indeed, in the wake of the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few large, systemically significant institutions.”

FCIC (Summary) • Our Corporate & Government (temporarily non-corporate) leaders totally blew it --- destroyed 25% of our national assets • Nothing has changed --- it’s actually more concentrated • The effects will last a generation • What is your fiduciary duty in face of these “general economic conditions” (3d ROT) ? • 1 obviously – Read the FCIC Report • 2 analyze investment strategy in light of Report

“Overall Investment Strategy” (Equities) • 60+% of all trades are by computers & algorithms • (Anne Hathaway moves Hathaway Berkshire!) • 7000 publically traded domestically down to 4000 and dropping • Stock exchanges merging & oligopolizing • “Fraud a week” club • If market perfect, over long term cannot beat it • So only way to beat it is with inside knowledge? • Raj Ratnaram; Bernie Madoff • What about AG Holder & Goldman Sachs • What can we learn from “Linked In”: 43 to 120, and now short sellers licking chops…

“Overall Investment Strategy” (Fixed Income) • Bill Gross says “get out now”…. • Interest rates near zero • Inflation heating up • Possible bubble in Treasuries (of all things….) • Most active : used car loans (FT)

“Overall Investment Strategy” (Real Estate) • I dare sayeth naught • Homes still imploding --- second mortgages due to disintegrate, foreclosures still at furious rate, unemployment still out of control • Commercial Real Estate depends on consumers having jobs and money to spend

“Overall Investment Strategy” (Commodities) • Commodity Futures Modernization Act of 2000 • Took the lid off regulation • Allowed speculators free access • (2008 gas price spike – finally acknowledged to be speculator-led) • Glencore • Private goes public • 60% zinc, 50% copper, 45% lead, 38% aluminum, 33% coal (3d pty) • “could one day become a sea of economic troubles” (FT)

A Bad Analogy, But… • Back in ‘70’s – slick black new limousine • Ran ok w/some problems • ‘87: 500 pts – quick repair • ’97: LTCM & Asian meltdown – larger repair • “00-02: 3 down years, 1st since Depression: smoking, leaking, chugging, barely drivable • ‘08: engine & transmission fell out • Query: Do you keep going back to the same used car salesmen, to get the funky old hunkojunk to run again?

Re-Thinking Fiduciary Duty • The Usual Theory • Go Into the Casino, Place Your Bets, and Use the Best Bookie You Can Find, to Maximize Returns • Another Theory (Hugh O’Reilly, Canada) • Just Keep Your Promises • LDI : Liability-Driven Investments • Make Sure You Pay What You Promised • Nothing More & Nothing Less

Re-Thinking (2) • In Next Decade, 82% Economic Growth Will be Outside the US & 18% Domestic • One Theory • Invest heavily abroad – to seize piece of 82% • Invest in taking jobs to Brazil, Russia, India, China (BRIC) • Invest in their bullet trains, infrastructure, manufacturing & service sectors • And incidentally drive your p/b’s States into bankruptcy, and decline --- loss of jobs, income, stable security

Re-Thinking (2) cont… • Another Theory • Invest in securing solid, stable, safe retirement environment for your participants & beneficiaries • Roads, Bridges, Dams, Water Systems • Alternate Energy Sources • Homes & Apartments for Participants & Beneficiaries • Invest in Your Own State • E.g., 86% California public retirees stay in California • Invest in Silicon Valley “stay-homes”, entertainment, agriculture

This Would Seem MANDATORY • (except in eyes of Wall Street, who might not make the same exhorbitant fees shuffling paper around) • Look again at ROT 3, 1992:an overall investment strategy having risk and return objectives reasonably suited to the trust.(c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:(1) general economic conditions; (2) the possible effect of inflation or deflation;(3) the expected tax consequences of investment decisions or strategies;(4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;(5) the expected total return from income and the appreciation of capital;(6) other resources of the beneficiaries;(7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and(8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries….”

Duty to be Pro-Active? • One Theory: “Passive” Investors • We go “shopping” amongst limited products investment managers bring to us from Wall Street • Another Theory: Time to be active investors? • Demand of investment managers they bring certain products? • Create own partnerships to invest in private equity ? • Create own partnerships to build own hedge funds? • Develop own in-house capabilities to do all this? • (See Australia, See Canada….)

Or…. Do you simply continue to give billions to Wall Street to mis-manage, to spread risk to you and keep bonuses for themselves? Not Rhetorical Question Two Banks (JPMC & GS), One Year 2010: $35 Billion for Bonus/comp packages for themselves (entire California budget crisis is only $25 billion)

Or, to put it another way • “Instead of the financial world being the lubricant for business, they are out there manufacturing products with no utility whatsoever except for generating fees….Somebody’s got to do something about Wall Street. It is destroying the country.” • Gerald D.Hosier, after winning punitive damages v Citigroup & SmithBarney, re “safe” muni bond fund (NYT, Easter Sunday, 2011)

To Summarize • Great Certainty re Corporate Governance • YOU MUST • Great uncertainty: How to do that? • By Re-Thinking What Your Fiduciary Duty Is • ---It is NOT to be a lemming and follow the crowd

Corporate Governance & Your Fiduciary Duty